Investors may seek to sell interests in private equity funds or real estate funds for a number of reasons, either strategic or necessitated by other concerns. Those reasons, in turn, will influence an investor's perspective in a secondary transaction, the type of transaction that will meet the investor's goals and the conditions upon the transfer that the investor is willing to accept.
Navigating the consent process can be arduous and each stage of the process can present hurdles to successful completion of the transaction.
Reasons for a secondary sale transaction are as varied as investors themselves. After a portfolio review, an investor may decide to realign its portfolio by selling certain types of fund interests. For example, if the investor determines that it is overexposed to a particular sector, such as large buyout funds, a secondary transaction can help reduce that exposure quickly compared to a more prolonged adjustment by adding new funds in different sectors. Similarly, after an asset allocation review, an investor may need to reduce its level of investment in private equity or alternative investments.
In another instance, an investor with a mature private equity programme may determine that it needs to reduce the number of relationships in its portfolio and focus on fewer, more strategic relationships. A secondary transaction can be one of the most efficient ways to reach that goal. In addition, an investor could determine that managing the number of funds and relationships is too costly based upon, among other things, the time commitment required of its investment professionals. A secondary transaction again presents an efficient route to take in reducing these relationships.
Secondary transactions can be structured in a number of ways to meet the needs of the investor. A sale transaction is the simplest and most common type of secondary transaction. However, other types of transactions may be available as well. An investor wanting to reduce the number of relationships being actively managed could effectively outsource the management task through a discretionary advisory arrangement or some sort of “captive” partnership, where the investor retains significant indirect ownership with an advisor managing the portfolio through a separate vehicle.
Whatever the type of transaction, most will require the seller to transfer the interest in the fund to another party. While funds vary from agreement to agreement, consents of the general partner or manager will be required at some stage of the process.
First, the manager will need to allow the seller to share confidential information about the fund with potential purchasers. This is usually the first point at which the seller will disclose its sale plans to the manager and provides the seller with the opportunity to explain to the manager its reasons for pursuing the transaction and its planned sale process. The outcome of these discussions often sets the tone for further dealings with the manager on the sale process. This is also the manager's first opportunity to raise its concerns.
At a minimum, the seller will be required to obtain confidentiality agreements from each prospective buyer. During the sale process, the potential buyers will conduct due diligence on the fund and discuss the fund with the manager. Some managers may impose further limitations as a condition to participation in the due diligence process.
The final step in the consent process occurs after an agreement has been reached by the buyer and the seller, and the sale is ready to close. Virtually every fund agreement requires the consent of the general partner or fund manager for a transfer of any interest in the fund. Most current agreements broadly cover any type of transfer, including a transfer of only the economic interest (as distinguished from a complete transfer of the entire fund interest on the books and records of the fund) . In addition, many fund agreements provide that the decision to consent to a transfer is in the manager's sole discretion.
Completing a secondary transaction can be time-consuming and, sometimes, difficult
This last step in the process – the consent to the transfer – can be the most difficult. All three parties to the transfer – the buyer, the seller and the manager for the fund – may have different goals and interests in completing the transfer process. For example, a seller that is trying to reduce the number of relationships in its portfolio may want to assure that it achieves a clean break from the fund. As a consequence, the seller may seek a release from any potential contingent liabilities to the fund. The manager may have the exact opposite goal – especially when the seller is more substantial than the buyer or when the manager does not know the buyer. And, to further complicate things, the buyer may be indifferent on these points.
NAVIGATING THE CONSENT PROCESS
Like any negotiation, the consent process for a transfer provides opportunities for each party to advance its interests. When faced with a possible sale transaction, fund managers can react quite differently. Some see an opportunity to meet a new group of potential investors. Some are offended. Others, particularly those that have been through a number of transfers, take things in their stride and already have processes and procedures in place to facilitate the transfer. The ability of the seller to deal with these varying points of view will determine its ability to achieve the goals that it has for the secondary transaction.
During the first stages of the sale process, many managers want to limit the universe of potential buyers that the seller may share information with. At the same time, the seller will want as few limitations as possible. Both parties will have to be sensitive to the concerns of the other and focus the discussion on the issues that are driving the request. Managers may also seek to limit the type of information that can be shared with prospective buyers, particularly at the early stages of discussions. Although this may present a burden to the seller as it seeks to deal with a number of buyers, providing sufficient information to potential buyers at the initial stages may require a compromise. During the later due diligence stages, most managers will agree to share more information with a smaller pool of potential buyers.
There are a number of other potential issues that may be raised during the consent process. Funds in the market will often seek to have a transferee commit to their next fund (a “stapled commitment”). Other funds may have issues on the horizon – extension of the investment period or fund term and other amendments to the fund agreement – that they want to have preapproved by a potential buyer. The buyers may also have particular issues that they want to pursue with the general partner, including negotiating an appropriate side letter. As noted above, a number of issues will also arise in negotiation of the transfer documents themselves.
Most importantly, a seller has to be prepared to be the instigator in completion of the transaction. Assisting in the completion of a transfer is likely to be very low on the list of priorities for the managers of the fund. Naturally, they are more focused on their business of investing and managing their portfolio investments. And, in many cases, the buyers may be in no hurry to complete the transaction. Consequently, the seller and its advisors need to keep the process moving.
Completing a secondary transaction can be time-consuming and, sometimes, difficult. However, being aware of the issues confronting all of the participants can make the process more manageable and bring the sale to a successful conclusion.
Dulcie Brand is a partner in the Los Angeles office of law firm Pillsbury Winthrop Shaw Pittman.